In recent years many people have lamented the decline of manufacturing in the USA. However, it's not really accurate that manufacturing output has declined in our country, rather it has been manufacturing jobs that have diminished. While many pundits have asserted that jobs are being sent overseas to countries with lower labor costs, this ignores the significant role that automation, technology, and process improvement are playing in manufacturing.

The following video tour of the Tesla automobile factory is breathtaking in its efficiency and level of robotics and automation. I had the opportunity to tour the Mercedes Benz factory in Sindelfingen, Germany in 2001 and while it also had an impressive level of robotics, the Tesla factory seems to have taken it to the next level.

When looking for business acquisitions, buyers often look for sets of systems that work together to produce products and services in an efficient, consistent, repeatable manner. If you want to build a more marketable and valuable business, think about the ways you could use technology and better processes to make your business more efficient, while lowering defects and waste.

The story of Whole Foods and its founder, John Mackey, is the quintessential entrepreneurship story. According to Wikipedia, John Mackey and Rene Lawson borrowed $45,000 from family and friends in 1978 to open a small natural foods store called SaferWay in Austin, Texas. When the couple were evicted from their apartment for storing food products in it, they decided to live at the store. Because it was zoned for commercial use, there was no shower stall, so they bathed using a water hose attached to their dishwasher. Two years later they brought on partners who owned another grocery store and formed Whole Foods Markets.

As of early 2014 they: employ 80,000 people; provide products to raving fans from 373 stores operated in the US, Canada, and UK; have a $19 billion market capitalization; and in the prior year had sales of nearly $13 billion, profits of over $550 million, and paid taxes of $343 million. Following is a video from Reason TV of John Mackey in which he makes a moral case for capitalism.

I don't fault business buyers for being cautious when acquiring a company. However, it is not uncommon for this type of cautiousness to result in a fundamental error when using a Discounted Cash Flow (DCF) approach to value, which will significantly and inappropriately undervalue a business.

In a DCF approach you project the likely future cash flow of the business and then discount it back to the present at a rate that is commensurate with the risk of the investment. The theory is that the value of a business should be equal to the present value of all future cash flow.

As a business broker, the mistake that I see some people make is that they use poor performance assumptions for the business while using an unadjusted discount rate that is appropriate for the risk of the business. Let me give an example:

Assume that for the size, industry, and risk profile of a business that the discount rate is determined to be 18%. Assume that three years ago the business had $900,000 of Operating Free Cash Flow (OFCF), two years ago it had $950,000 of OFCF, and last year it had $1 million in OFCF. Also assume that the market and activities the business has been involved with have lead to this steady growth and absent a significant change, a similar level of growth is believed to be realistic for at least the next 2-3 years. Given this information it may be realistic to assume that next year the business will have somewhere around $1,050,000 in OFCF.

A risk-adverse buyer or business broker may say, "I like the business, and while I think $1,050,000 in OFCF for next year is a reasonable assumption, what if the business doesn't perform at that level? There are a variety of things that could go wrong with the business so rather than projecting $1,050,000 in OFCF, I'm going to use the last three year's average of $950,000 and keep that cash flow constant going forward in my projections." The problem with this is that this will put OFCF at roughly 10% lower than it is actually projected to be in the coming year, and it will likely be an even wider divide in the future if the business continues to have similar growth. However, part of the reason that an 18% discount rate was used rather than a 5% discount rate is to take into consideration the risk of lower performance. If a buyer is projecting much lower performance, than it is inappropriate to use the 18% discount rate because that would, in essence, double count the risk.

If you are going to project lower financial performance than you believe is realistic, then you need to be using a lower discount rate because you've already modeled the risk into your projections. When Warren Buffett acquires companies he analyzes the business enough that he is comfortable with its risk, and he uses conservative projections but utilizes a very low discount rate based on a "risk-free" long-term US Treasury yield (which is currently under 4%). While I would not advocate using that low of a discount rate for a small privately held company, if you are going to use projections that show lower financial performance than you expect, a lower discount rate needs to be utilized than if you are projecting more realistic performance.

For business owners it is no surprise that cash flow is essential to the survival and success of a business. The cash conversion cycle formula can help you monitor and measure how effective and efficient your business is at converting its activities that require cash, ultimately, back into cash. In my experience as a business broker, I know that even if a business seller doesn't think this is important to measure, a business buyer likely will - so it's something that someone preparing for a business sale may want to consider. In the following article, Brian Schkeryantz, managing director of Gryphon Growth Group describes why the cash conversion cycle is important, the formula to calculate this, and how to use this information:

Benjamin Graham, who had a strong influence on Warren Buffett’s investment philosophy, believed in self-reliance and not making decisions based on what others think (whether that be Mr. Market, or other advisors). The following quote from Graham provides good food for thought for buyers of small businesses: “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”Many small business buyers make the mistake of relying on advisors to tell them whether or not they should buy a business. The problem with this is that the reason that many attorneys, CPAs, management consultants, and money managers do what they do rather than buy and run non-professional services businesses is that they are not comfortable with general entrepreneurial risk. Consequently, they may not be the best people to ask “should I buy this business or not?” Rather, a better use for these professionals is to have them help you to better understand a prospective acquisition, its risk factors, and its pros and cons. Then armed with that information YOU can make a decision about whether it makes sense or not for your situation, objectives, and risk tolerance.

Does your business have significantly aged inventory? If so, it may not only be hurting you in the short-term from a cash flow standpoint, but you also may be surprised that you won’t likely recover its value in the sale of your business. Recently, I was working on a transaction where I was helping a buyer with the acquisition of a multi-location retailer. When we started to evaluate the business we learned that a significant portion of its inventory was aged beyond three years. The business owner argued that it was the nature of the business for some inventory to move more slowly, and that when it eventually sells to a customer it will be at a full retail price or perhaps only slightly discounted from original retail. However, that ignores the opportunity cost of having capital tied up in slow-moving inventory. For example, if I paid $100 for a piece of inventory that I plan on selling for $150, and then it takes me five years to sell that piece of inventory, the present value of the retail price, if using a 20% discount rate, would be $60 – in other words from a financial analysis / opportunity cost standpoint, in essence, I lost $40 on my investment. If I had to hold it another five years before selling it (and assuming I don’t discount it at that point in time to get it sold) the present value would only be about $24, for an effective loss of $76. Another simple conceptual way of looking at this is if I buy a piece of inventory for $100 and plan on selling it for $150 and it takes me five years to sell it, I made a $50 gain before SG&A expenses (or 50%), but that really equates to only about a 10% average gain per year because of the long holding period. If, in contrast, after one year I liquidated the piece of inventory at cost, and then reinvested that into an item that turned three times at a price of $150 over the next four years, then that original $100 investment generated a $150 gain over that same five year period, for an average annual gain of 30%. Even if you believe that your significantly aged inventory continues to be relevant, if it has not sold in 2-3 years, how much longer will it age before someone buys it? Is it prudent to hold onto inventory that may continue to sit on the shelf for years, when instead that capital could have been devoted to more marketable items? While you may not be concerned about aged inventory, a business buyer will be. Business buyers typically pay full price for inventory that is current, but when it starts aging beyond a year (depending on the industry - in some - like fashion retailers it may be less time) there is usually a healthy discount (often 50% for 1-2 year aged inventory) and/or if it gets beyond 2-3 years many business buyers don’t want to buy it at all, and sellers often just throw it into the deal at no cost.

Here are links to a couple of additional articles on this topic related to retailer inventory:

At Codiligent business brokers we've always aspired to create the best business sale introduction packages and confidential packages in the industry. The development of our packages has been based on experience, feedback, and including what we'd want to see if we were buying a business. Our hope is that by having better information packages we lower uncertainty for buyers which may lead to not only a more marketable business but also a higher price for our clients.

Over the years we've seen that our introduction packages are significantly different than those from many other business brokers. In fact, many business brokers don't even use a non-confidential introduction or teaser package, rather they rely on a short 4-7 sentence ad and then the business broker will require a NDA before providing any sort of information package. Because a lack of an introduction package is so common, there have been times that I have questioned if Codiligent's format for its introduction packages is over-kill. Does it really make a difference? Sure, we receive continual positive feedback from appreciative buyers who compare our information packages to others (or the lack thereof), but does that really mean that our packages generate more interest? Or have we just created more work for ourselves?

We now have seen research that confirms that statistically our approach is more effective! Axial Network, a membership organization of over 14,000 professional private capital deal makers, analyzed 8,732 investment teasers / introduction packages for businesses. They looked at titles, descriptions, and financial details to find out what characteristics lead to a more successful introduction package or investment teaser, defined as one that generates more interest relative to other advertised businesses on the market.

The following infographic shows the findings from their research. The characteristics and elements of Codiligent business brokers' introduction packages are the same ones that the research indicates makes such a package effective!

While this is a promotional video for Alibaba, it's a great entrepreneurial success story of a couple of guys identifying a need and then figuring out how to fulfill it. Entrepreneurship has been on a slow 30-year decline in the USA. What can we do to encourage more people to pursue entrepreneurial ambitions?

Sometimes when a seller and their advisors evaluate a deal and consider risk factors, they fail to take into consideration the risk associated with not selling.

Recently, I was representing a strategic buyer in an acquisition. On the surface the Letter of Intent we negotiated would, to most outsiders, not look very attractive to the seller: the buyer agreed to a down payment of less than 20%, and the seller note would have no payments during the first year. Yet, the sector the business was in was becoming less relevant and was in a state of decline. The seller's business had experienced an erosion of both sales and margins, had excessive aged inventory, and was not much above break even despite the fact that they were paying real estate rents that were a little below market. To make the business more viable would require not only a new strategy, but also a significant additional investment of capital, time, and energy. In light of the condition of the industry and business our offer was very reasonable.

When we negotiated the deal the seller did not have representation. After we got past due diligence and my buyer client's attorney submitted the binding purchase agreement, the seller brought in its attorney. The sellers then backed out of the deal. I'm pretty certain that the attorney, not understanding how precarious the seller's business was, advised the seller of the great risk associated with carrying such a large seller note. Unfortunately, I was not able to re-persuade them that given the risk factors associated with their business, the price and terms were very reasonable. This was unfortunate because unless the seller significantly turned their business around their odds of selling it would be exceptionally low, and if they were able to find a buyer for it the terms would likely be similar to, or worse than, my buyer client's offer. My buyer was willing to do the deal because of strategic implications, whereas a financial buyer likely wouldn't complete an acquisition at any price.

One of the problems that I sometimes encounter with sellers and their advisors (particularly with under-performing businesses) is that they are so concerned about the risk of a seller note default or of manipulation of an earn-out that they forget that they also have significant risks associated with not completing a deal. Following are some of those risk factors:

The seller won't be able to find another buyer for the business in the future.

If the seller does find another buyer who is interested, will that buyer pay a higher price or better terms than the current buyer?

Will a future buyer be as financially strong as the current buyer and/or have the vision and management skills to improve the business and make it more profitable?

Will the seller be able to find a buyer without hiring a broker and paying a commission? In my recent situation the buyer was engaging me, and the seller was not paying a commission.

Will the seller be able to find a competent business broker or investment banker that will take them on as a client? For the business I described, I wouldn't have taken the business on as a sell-side client because the odds of success would have been too low for me, and I suspect other business brokers and investment bankers would feel the same way.

If the seller does find a motivated buyer, will the buyer complete the deal after conducting formal due diligence? In this case my buyer client had made it through due diligence and was still willing to do the deal, but it's not uncommon for a buyer to terminate a deal after completing due diligence.

The business will continue to decline. If it starts losing money, not only will the owner have to financially feed the business but marketability will be further eroded and the exit option may be to simply shut the business down.

If the decision is made to liquidate the business, the seller may be surprised at how little he may get for the business' assets and inventory when not part of a going concern.

Not only should the seller in my deal have carefully considered these risk factors, but they also should have thought about the risk/reward relationship for the buyer. By thinking about the deal in terms of the time and money required for a buyer to improve the business' performance and what type of realistic return that would produce, it would be easy to discern that a more seller-favorable deal structure than we had agreed to would quickly become highly unattractive for a rational buyer.

If you are a seller, and your attorney or advisors tell you that a deal is bad because of the risk of non-performance by the buyer on a note, before you back out of the deal, I'd encourage you to consider the risks of not completing the deal, and whether the alternate risk/reward relationship you are proposing would likely be agreeable to any rational buyer.

While I am a strong advocate for being as prepared as possible for a business sale, I also know that some business owners hesitate to engage a business broker or investment banker to attempt a sale because they recognize issues and imperfections that they believe first need to be remedied. While there are, indeed, some issues that will significantly impact marketability, others may not.

No business is perfect - all are in a state of imperfection, with continual improvement possible. If you perceive that your business has to be perfect in order to attract a buyer who will pay a good price, you may be wrong. In fact, trying to present a business as being "perfect" can actually impair the marketability of the business.

There are a few reasons for this:

Many business buyers want to acquire a company that they can improve by using their talents, skills, and ideas. If the business is positioned as being perfect then it may be difficult to determine how to improve the business.

It is extremely important to establish trust with a buyer to get a business sale closed. If a buyer asks about problems or business weaknesses and the business broker or seller responds that there are no problems, it will not be credible and will cause the buyer to question the seller's integrity and to be skeptical of other representations.

If a buyer believes that there aren't any obvious improvements that can be made to the business, it may actually result in a lower price since there may be less future financial up-side potential.

A business buyer who has looked at other businesses will understand the realities of business ownership and won’t expect perfection. Instead of marketing the business as being perfect, a better approach is to share weaknesses of the business but position them as fixable problems and opportunities. A good business broker or investment banker can provide perspective on what to fix, and what to leave for the next owner to fix.